PIMCO - Investment Outlook- May 2006 "As GM Goes, So Goes the Nation" Page 1 of 4

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Investment Outlook
Bill Gross | May 2006

As GM Goes, So Goes the Nation

I’m not going to affirm the old saw about what’s good for General Motors is good for the nation, or even turn it
on its head and suggest that what’s bad for General Motors is bad for the nation. Mainstreet Americans know
that the auto industry in terms of its dominance of U.S. economic activity is not what it once was. They also
know that the industry is under siege from foreign competition and that a series of mistakes made over several
decades by both management and labor have compounded the predicament. But the U.S. economy for better or
worse, now stands on service and finance, as opposed to manufacturing legs. “What’s good for Microsoft or
Citigroup” would probably be a better fit for the modern day version of Charles Wilson’s metaphor even though
Gates or Prince would never acknowledge it.

But as an entropic symbol of U.S. manufacturing aside, I think it is important to recognize that General Motors is
a canary in this country’s economic coal mine; a forerunner for what’s to come for the broader economy. Their
mistakes have resembled this nation’s mistakes; their problems will be our future problems. GM commands the
headlines today, but as General Motors goes, so goes the nation. Following their progress over the next few
months and years will be like getting a 2010 Wall Street Journal in June of 2006. But rather than describe in
detail every similarity of General Motors and the U.S. economy, I invite you to digest the following schematic for
its rather frightening similarities and possible future consequences. I will sum up my own conclusions in the
paragraphs to follow.

If the U.S. and General Motors have similar flaws and indeed symbiotic fates, they appear to be conjoined
primarily by the uncompetitiveness of their existing labor cost structures and the onerous burden of their future
healthcare and pension liabilities. That is not to say that other automobile manufacturers or countries don’t
share similar characteristics: they do – but GM and the U.S. are compared here because of their historical
dominance and therefore the influence that they will have on investment markets as they struggle to adjust. If
GM is a canary, let’s hope for the canary’s long life, but be mindful of its chirping deep in the mineshaft of future
events that speak to broader implications for the U.S. economy.

Because diminished labor cost competitiveness and excessive future unreserved liabilities are descriptive of
both GM and the U.S. economy, GM’s efforts to survive and ultimately prosper should be our own as well.
Although the following graphic contains my own assumptions, I am struck by several primary investment
conclusions:

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1. The current attempt on the part of GM to address the high cost of its labor draws a comparison to

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potential future U.S. efforts to do so via currency devaluation. While a company must deal directly with
its employees and or its unions in order to lower wage/benefit expenses, a country – certainly a
capitalistic oriented one – goes about it in another way. By depreciating the dollar, U.S. Treasury or
Federal Reserve policies aimed in that direction explicitly do the same thing. Such policies make our
products cheaper to buy than those of competitor nations. In terms of global purchasing power
experienced by America citizens, a significantly lower dollar in turn leads to declining real wages which
is the ultimate consequence in order to restore competitiveness. My point is that the survival tactics
employed by General Motors in the form of contract renegotiations (the heavy lifting of which is now
being expressed via its parts supplier Delphi in bankruptcy court) will likely be replicated at some point
via U.S. economic policies emanating from the U.S. Treasury and Federal Reserve. Look for an eventual
abandonment of our stated mantra of a “strong dollar policy” for something more elusive but nonetheless
potently obvious. Look also for the Fed to support such a policy – not openly or in public statements –
but via a substantive period of low real interest rates compared to history. This one-two punch by the
Treasury and the Federal Reserve amounts to what is known in economic circles as a competitive
devaluation, a maneuver that may or may not be welcomed by competitor nations with mercantilistic
intentions of their own. Nonetheless, at some point in America’s future, a rather drastic rebalancing of
wage rates compared to primarily Asian competitors will be required and these are the policies that
accomplish that.

2. Perhaps the most significant comparison between GM and the U.S. economy lies in the recognition of
enormous unfunded liabilities in healthcare and pensions. Reportedly $1500 of every GM car sold in
dealer showrooms goes to pay for current and future health benefits of existing and retired workers, a
sum totaling nearly $60 billion. The total future healthcare liability for all U.S. citizens can be measured
in the tens of trillions.

GM’s pension and this country’s social security liabilities are of similar magnitudes. While GM’s plan is
currently fully funded, the necessity for future contributions, especially if investment return assumptions
are not met, are substantial. “I have a social security system hooked to our balance sheet,” admits GM
CFO Fritz Henderson. Since America’s existing social security scheme is for all intents and purposes a
“pay as you go” funding plan, the U.S. balance sheet is tipped even more to the liability side.

How are we to pay for this future burden of healthcare and social security expenses? Aside from
contractual legislative changes to both areas (which are surely just around the corner), the way a
reserve currency nation gets out from under the burden of excessive liabilities is to inflate, devalue, and
tax.

Another way the U.S. could escape the burden of its future liabilities is to “grow” its way out, much in the same
manner GM is attempting to make its models more attractive and relevant to current car buyers. We could do
that by accelerating relative productivity gains, by emphasizing innovation, and upscaling education. Other
nations however, understand the same rules and it will be difficult to “grow” assets and/or reduce liabilities via
increased savings if we have a reduced “product line.” With our manufacturing and service base being
increasingly hollowed out by foreign competitors, the primary export we have that can be made more attractive
are our Treasury bonds in the form of higher relative yields. It will be an easier task, in fact for GM to renovate
its product line than for the U.S. to revamp its.

Owners of these liabilities (either existing/future debt holders, or tax paying corporations/citizens) will likely be
the sacrificial lambs of the future. Investors, therefore, should factor in an increasing propensity for higher
inflation in future years as debt principal is eroded much like the shaved edges of a Roman coin. Higher taxes,
as well, are just around the corner. Finally, currency devaluation effected through a low Fed Funds policy vs.
competitor nations and/or global policy coordination should apply the coup de grace for foreign holders of U.S.
liabilities. Chinese, Japanese, OPEC, and other substantive holders of U.S. Treasuries will have two ways to
lose in future years: they will watch U.S. inflation erode their principal and on top of that the real dollar value of
their global purchasing power will decline as the dollar sinks. Actually, the same applies to U.S. citizens
although the decline in global purchasing power can be masked by domestic asset appreciation in the short-
term (houses, stocks).

If the U.S. chooses to pursue many or most of the above policies, the investment implications are significant,
although it must be recognized that I am not speaking to “overnight” developments but instead to changes that
should occur in future years. Higher inflation, higher personal and corporate taxes, and a lower dollar point U.S.
and global investors away from U.S. assets and toward more competitive economies less burdened by health
and pension liabilities – those personified by higher savings rates and investment as a percentage of GDP.
Need I say more than to sell U.S. assets and buy Asian ones denominated in their local currencies; or if
necessary to hire a global asset manager with sufficient flexibility and proper foresight to thrive in an increasing
difficult investment environment?

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William H. Gross
Managing Director

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#$%%& '

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